Investment Basics

Generally speaking, investors have been more inclined to invest in bonds than they have been to invest in domestic equities. As more and more investors see that bonds are actually more risky than equities, particularly dividend payment securities, they are becoming more interested in understanding what the true, financial risks are for their bond portfolios. There are two simple ways that investors can gauge just how badly their bond portfolio will respond to changes in interest rates.

1) Using Treasuries as a gauge. For portfolios that are modeled after treasury bonds, looking at your bond portfolio's duration and the yield (or its SEC yield if you invest in funds, which is the more-accurate measurement of a portfolio's yield found on the fund company's website) is help you guestimate a fairly accurate risk level. If this is your case, then a 1% increase to Treasuries will translate into the fixed income portfolio's duration minus its yield. So, for a bond portfolio with a 10 year duration and a 4% yield, a 1% increase to Treasury rates will impact the portfolio by 6% (on the down side). You figure this out by taking 10 (duration) and subtracting 4 (yield). Therefore, a 1/2% increase to rates will have a negative impact of 3% on your bond portfolio. However, not all fixed income portfolios are built with Treasuries as the benchmark or to mimic Treasuries. Corporate bonds are a different beast, which leads us to the second way to guestimate risk.

2) Using duration and interest rate risks for a gauge. For investors who hold a fairly elaborate bond portfolio that is more about corporate bond holdings than Treasuries, this second method might work best. In this method, all an investor does differently is multiply the duration by the anticipated increase in rates. For example, if rates are to increase 1.5% and the bond portfolio's duration is 5 years, the risk to the portfolio is 7.5%. You come to this conclusion by multiplying 5 (the duration) by 1.5 (the rate increase).

Comparing the Two Methods

Both methods will provide different values, which is not normally a problem because a bond portfolio will often be more like a Treasury portfolio or more like a Corporate Bond portfolio. Here is how those methods will vary:

Method 1

In the case of a portfolio with an 8 year duration, a yield of 3.5%, then the risk is 4.5% if rates on Treasuries increase by 1%.

Method 2

Using the second method, that same portfolio of corporate bonds would expect to see a risk of 8%, a fairly wide gap between the two methods, indeed.

It therefore becomes increasingly important for bond investors to understand how they have invested their money. This is important not only from a risk assessment perspective, but also from a portfolio construction perspective. While investigating how you have invested your money is ultimately up to you, utilizing one or both of these methods can help you get a feel for what the risks of that portfolio may be.

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Chris has more than 17 years of financial services experience. He is a regular contributor to the Mutual Fund Site, where mutual funds from T Rowe Price Mutual Funds to Vanguard Mutual Funds are reviewed regularly.